Friday, June 17, 2016

Everybody loves trading or investing in ETPs. ETP is the acronym for exchange-traded products, which include both exchange-traded funds (ETF) and exchange-traded notes (ETN). They seem simple, transparent, easy to understand. But there are a few subtleties that you may not know about.

1) The most popular ETN is VXX, the volatility index ETF. Unlike ETF, ETN is actually an unsecured bond issued by the issuer. This means that the price of the ETN may not just depend on the underlying assets or index. It could potentially depend on the credit-worthiness of the issuer. Now VXX is issued by Barclays. You may think that Barclays is a big bank, Too Big To Fail, and you may be right. Nevertheless, nobody promises that its credit rating will never be downgraded. Trading the VX future, however, doesn't have that problem.

2) The ETP issuer, together with the "Authorized Participants" (the market makers who can ask the issuer to issue more ETP shares or to redeem such shares for the underlying assets or cash), are supposed to keep the total market value of the ETP shares closely tracking the NAV of the underlying assets. However, there was one notable instance when the issuer deliberately not do so, resulting in big losses for some investors.

That was when the issuer of TVIX, the leveraged ETN that tracks 2x the daily returns of VXX, stopped all creation of new TVIX shares temporarily on February 22, 2012 (see sixfigureinvesting.com/2015/10/how-does-tvix-work/). That issuer is Credit Suisse, who might have found that the transaction costs of rebalancing this highly volatile ETN were becoming too high. Because of this stoppage, TVIX turned into a closed-end fund (temporarily), and its NAV diverged significantly from its market value. TVIX was trading at a premium of 90% relative to the underlying index. In other words, investors who bought TVIX in the stock market by the end of March were paying 90% more than they would have if they were able to buy the VIX index instead. Right after that, Credit Suisse announced they would resume the creation of TVIX shares. The TVIX market price immediately plummeted to its NAV per share, causing huge losses for those investors who bought just before the resumption.

3) You may be familiar with the fact that a β-levered ETF is supposed to track only β times the daily returns of the underlying index, not its long-term return. But you may be less familiar with the fact that it is also not supposed to track β times the intraday return of that index (although at most times it actually does, thanks to the many arbitrageurs.)

Case in point: during the May 2010 Flash Crash, many inverse levered ETFs experienced a decrease in price as the market was crashing downwards. As inverse ETFs, many investors thought they are supposed to rise in price and act as hedge against market declines. For example, this comment letter to the SEC pointed out that DOG, the inverse ETF that tracks -1x Dow 30 index, went down more than 60% from its value at the beginning (2:40 pm ET) of the Flash Crash. This is because various market makers including the Authorized Participants for DOG weren't making markets at that time. But an equally important point to note is that at the end of the trading day, DOG did return 3.2%, almost exactly -1x the return of DIA (the ETF that tracks the Dow 30). So it functioned as advertised. Lesson learned: We aren't supposed to use inverse ETFs for intraday nor long term hedging!

4) The NAV (not NAV per share) of an ETF does not have to change in the same % as the underlying asset's unit market value. For example, that same comment letter I quoted above wrote that GLD, the gold ETF, declined in price by 24% from March 1 to December 31, 2013, tracking the same 24% drop in spot gold price. However, its NAV dropped 52%. Why? The Authorized Participants redeemed many GLD shares, causing the shares outstanding of GLD to decrease from 416 million to 266 million. Is that a problem? Not at all. An investor in that ETF only cares that she experienced the same return as spot gold, and not how much assets the ETF held. The author of that comment letter strangely wrote that "Investors wishing to participate in the gold market would not buy the GLD if they knew that a price decline in gold could result in twice as much underlying asset decline for the GLD." That, I believe, is nonsense.

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37 comments:

(Leveraged) ETFs may also have excessive tracking errors. I have not done any systematic study, but briefly examined an ETF titled "ETFS 2X Daily Long WTI Crude Oil" (ticker 4RT6 in XETRA). In one year period from spring 2015 to spring 2016, the underlying non-leveraged index closed at roughly the same level, but the ETF shares (or NAV per share) lost about three quarters. Bloomberg currently puts 1yr return at -73.74%, taking into account a reverse split. Most of that loss cannot be explained by the fact that the ETF is supposed to replicate daily leveraged returns. Based on this, it is essential to have long-term data on how an ETF has performed against the (simulated) index, although some ETFs like physical gold funds (of reasonable size) can probably be safely assumed to track it quite faithfully. Of course, it is also important to remember the difference between daily and long-term returns, as pointed out in the post.

Sure, MOO order is executed during the closing auction. Nobody pays bid-ask spread.IB or any broker will just route it to the exchange for this auction. But note that you need to submit this order 10 minutes or more ahead of the close (based on NYSE or Nasdaq rules).

To comment on what Lauri said earlier, the discrepancies you witnessed between leveraged ETPs and their underlying indices really have 2 components: the first one is beta slippage, which is inevitable for products that only track day-to-day returns, even if the ETP tracks its underlying perfectly the slippage will still occur and it has a path-dependent quality. I believe Euan Sinclair talked about this in his book "Volatility Trading". The second component is the actual tracking error, this is very easy to model as you can simply compare the return of a perfectly tracking model of a index to the return of the actual ETP that has the same leverage. For highly volatile ETPs such as the JNUG & JDST pair, the tracking error alone can be more that 60% annually. There's also an observable linear relationship between the tracking errors of leveraged ETPs and the volatilities of their underlying indices. Low volatility pairs such as the SPXL and SPXS almost have no tracking error over a one year period.

Just for clarification: when you said "beta slippage", are you referring to the discrepancy between the long term (not daily) growth rate of levered ETP vs. the long-term growth rate of the unlevered ETP multiplied by the leverage?

Interesting observation that tracking error is linearly proportional to volatility. I imagine that is due to the transaction costs of frequent intraday rebalancing?

Thanks for your quick comment. Yes, and imo slippage is even more visible when you compare the performance of the leveraged ETP during any period when the underlying index's return is almost flat. But this quality is indeed path dependent, theoretically the "slippage" will turn into a compounding surplus when the security has consecutive movements in one direction (obviously not realistic over longer period of time).

I haven't looked into the reason but I suspect transaction costs is a big part of it.

Thanks for the quick comment. Yes, and the discrepancy is more visible during any period when the underlyng's return is flat. I haven't look into the reason for the relationship but I suspect transaction costs are a big part of it.